Electronic trading systems, such as Creditex RealTime® Platform, have brought great efficiency to credit derivative markets. Nowadays, traders or dealers representing large financial institutions (e.g., banks and funds) routinely use electronic trading systems to enter into credit derivative transactions involving large notional amounts. Each financial institution may hold multiple credit risk positions as a result of buying or selling credit derivatives. In the context of a credit default swap (CDS), which is the most traded type of credit derivative, a credit curve may be plotted for a reference entity to show the change in CDS spread as a function of maturity lime. Typical maturities may include but are not limited to: 6-month, 1-year, 2-year, 3-year, 4-year, 5-year, 7-year, and 10-year.
For each CDS position, a delta value may be calculated as a first-order derivative between the present value (PV) of the CDS contract and a corresponding CDS spread. The delta value may indicate how sensitive the CDS contract is in response to a one-basis-point (bps) move in the credit curve. A credit risk position, such as one corresponding to a CDS contract, may also be referred to as a delta position.
While being delta neutral overall (i.e., with respect to parallel shifts in the entire credit curve of a particular reference entity), a financial institution may still be exposed to short/long credit risk positions in successive maturities on the credit curve. FIG. 1 illustrates this problem. FIG. 1 shows an exemplary bar chart where bucketed delta values are plotted along a timeline to highlight one bank's credit risk positions at different maturities. Although all the positive and negative delta values may offset one another and thus add up to almost zero, the large delta variance the large variance of the delta positions could be problematic to the bank holding these credit positions. For example, as the credit curve in question changes slope for different maturity dates, the bank's profit and loss (P&L) will have to swing accordingly. In addition, the bank may be exposed to default gap risk if the delta values toggles between short and long positions too quickly in successive maturities.
Some credit derivative dealers have attempted to solve the above-described problems by engaging one another on a bilateral basis to reduce their risks, i.e., where they are able to find offsetting positions. While this approach provides some risk reduction benefits, it suffers from several limitations. For example, this bilateral process requires “trusted” counterparties due to transparency in disclosure of positions. One counterparty can only expect to mitigate risk positions for which the other counterparty happens to hold offsetting positions. Overall, the existing approach is labor-intensive, time-consuming, error-prone, and ultimately not scalable.
In view of the foregoing, it may be understood that there are significant problems and shortcomings associated with current risk-hedging techniques in credit derivative trading.